Ambac: Where a Smaller Portfolio Means a Bigger Stock Price

By

Jack Willoughby

December 21, 2013

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The bond insurer
Ambac Financial Group
emerged from bankruptcy in May with a portfolio of obligations on distressed assets that might never regain their full financial vigor. But properly managed, they could make Ambac shares an excellent value play.

Originally a municipal-bond insurer, the New York firm pushed into the booming residential mortgage- and asset-backed-securities markets in the late 1990s, participating in their growth before they imploded nearly a decade later. Ambac had guaranteed principal and interest payments to institutions on what, in some cases, turned out to be worthless collateralized-debt obligations and credit-default derivatives on mortgage-backed securities. By November 2010, and after more than five downgradings by rating agencies, Ambac faced missing an interest payment and was forced into bankruptcy. Shareholders were virtually wiped out.

Now reorganized, Ambac (ticker: AMBC) is running off its insurance contracts on about $189 billion in assets, with the aim of ultimately reinventing itself. It is set up as a "good bank/bad bank" with a general fund made up mostly of contracts to insure muni bonds, and a separate account that holds more toxic assets, including $16.7 billion of securities backed by mortgages and home-equity loans. The latter portion operates as a subsidiary, Ambac Assurance, supervised by Wisconsin's insurance regulator.

What's intriguing about this little-followed stock is that improving markets and Ambac's own initiatives give it a good shot at paying the insurance claims against it with much less than the $6.6 billion that it's set aside for that purpose. BTIG analyst Mark Palmer estimates that Ambac can settle the claims for about $5 billion. The remaining $1.6 billion would be a lot of found money for a firm with a market valuation of just $1.1 billion. The shares traded last week at $21, and the handful of analysts who cover the company believe they could be worth about 50% more within a year and substantially more in two or three years.

UNDER CEO DIANA ADAMS, a former structured-products professional at JPMorgan and Mitsubishi Bank, Ambac has done a good job of liquidating obligations. It has also gotten a few breaks. The U.S. recovery, particularly in housing, has bolstered the value of some of the mortgage securities it guarantees and has cut default rates. The firm insures $34 billion of structured-finance holdings, including $17 billion of mortgage-backed securities.

Ambac is one of several insurers suing big banks, alleging that they misrepresented the kinds of mortgages and other assets used in troubled securitizations. Encouraging for the insurer was a June court victory by insurer
Assured Guaranty
(AGO) over
Flagstar Bancorp
(FBC). In that case, the insurer received a 90% recovery on $116 million in claimed losses. In May, another guarantor,
MBIA
(MBI), got back roughly 70% on $165 million in claimed losses from Flagstar.

Ambac has two big suits: one against
JPMorgan Chase
(JPM) for $1.1 billion in claims and another against
Bank of America
(BAC) for $1.2 billion. A 70% recovery would mean $1.6 billion for Ambac.

The market also has aided Ambac's portfolio of municipal obligations. Since its 2010 bankruptcy, Ambac's muni borrowers have called more-expensive offerings and refinanced at much lower rates. (Ambac's obligation disappears once an issue is called.) Refinancings helped cut Ambac's muni obligations to $122 billion by Sept. 30, from $199 billion in 2010.

Although the insurer won't detail its activities (it declined to speak with Barron's), it's said to have been savvy about buying Ambac-insured bonds in the open market at deep discounts, thereby removing potential insurance payouts and acquiring an asset that could appreciate. Last quarter, for instance, it purchased $360 million of mainly student-loan-related credits for $65 million. Ambac's overall $189 billion portfolio has dropped 41% from $319 billion at year-end 2010. We estimate that it will be reducing its portfolio at an annual rate of $45.2 billion by year-end 2013.

Ambac has an estimated $5 billion in tax-loss carry-forwards that could shelter future income should Adams' executive team buy a profitable business. Although the firm is in the black (it had $231 million, or $4.98 a share, in net profit in the third quarter), it's unlikely to be able to use the whole tax benefit on its own. The carry-forwards could cement a purchase and set Ambac on a new course, possibly in mortgage insurance or back into public finance.

The Bottom Line

Ambac shares could jump 50% within a year and be worth even more further down the road if it continues to shrink its portfolio of obligations and wins a couple of pending lawsuits.

Be warned: Ambac is a speculative play that will require time to play out. Recently, it was disclosed that it guarantees $2.5 billion worth of debt issues from Puerto Rico, where many credits are shaky. The news pushed the shares, now around $21, down to $16, before they recovered. But 90% of Ambac's Puerto Rico obligations are considered less risky than other securities from that U.S. commonwealth because they're backed by specific revenues from tolls, sales taxes, and levies on gas, rum, and hotel occupancy.

The reward, in any case, seems to outweigh the risk. "It's a classic. You have misunderstood assets in transformation, a forgotten company overlooked by investors, and a real opportunity for profit," says shareholder David Marcus, founder of Evermore Global Advisors.

Andrew E. Gadlin, an analyst at Odeon Capital, says Ambac's stock could easily rise by $10 within 12 months, based on another $500 million in market valuation from retired insurance contracts and gains in book value through portfolio management. Beyond that, he estimates the lawsuits could be worth up to $2 billion more than current reserves reflect. That added value could merit a $50 share price, he asserts.

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